If the average return of your plan is significantly off of the S & P 500, have you checked your 401(k) fees? The Government Accounting Office reported that cutting 401(k) fees (investment expense ratios) by just 1 percent yields a 17 percent difference in asset value over 20 years.1 Morningstar, the well-respected investment research firm, said that investment cost is a better predictor of future performance than their star rating. Professionals know that one of the considerations must be investment fees.
When dining out the restaurant makes your decisions on eating related expenses. They make no guarantees on the long-term health effects. They likely focus on making it tastes good. We don’t know how much of the meal cost is profit to the restaurant and how much paid food costs, rent, salaries, etc. Our only cost decision is how much to tip the server. In contrast, when we cook at home we know how much of what we paid for goes to our nutrition or our taste buds. However, if we serve some bad stuff out of our refrigerator to our neighbors and they get sick, we are liable.*
401(k) fees and investment costs
There are three categories of expenses: administrative fees, investment fees and plan consulting fees (broker and/or investment advisor). Combined, these represent total plan cost. The estimates below come from Demos’ report, The Retirement Savings Drain.
- Administrative costs. Expenses for keeping records, providing statements, etc. Administrative fees generally range from 0.2 percent to 0.4 percent annually.7 Administrative and plan consulting fees may be paid by the plan sponsor or participant. Some plan services may be assessed in a wrap charge.
- Investment fees to investment companies for salaries, research etc. whose investments your company chooses. These fees generally range from 0.5 percent to 1 percent annually.8 Investment fees are always paid by participants (deducted from plan assets).
- Trading costs. Costs when you buy and sell investments or your investment company does on your behalf. These costs are always paid by the employee.
- Plan consulting fees are payments to the investment broker (commissions) or investment advisor (fees). You can choose to pay the administrative and broker and investment fees and get a tax deduction. This maybe a particularly good option if you are the owner.
Many of these costs are expressed an expense ratio for each investment you select.
Are employees getting their return on your investment menu?
The fees charged can be affected by the investment strategy the plan sponsor considers in selecting investments. A 401(k) plan currently allows an employee a $22, 500 contribution. Further, it allows the employer to make a tax-deductible matching contribution Compare that to an IRA of only $6000 and you have a significant employee benefit. I see this as the return on the administrative costs for plan compliance and plan savings design. The return on investment is dependent on the extent to which you offer a match and the employees actually saving near the legal limit.
Now the hard part. Do your employees get a return for the costs that you pass on to them? Let’s say that the investments you choose get a 4% gross return, has an expense ratio of 1.2%, has trading costs of 1.2% and you incur a wrap fee of .6%.
Net return = Gross return – expense ratio – wrap – trading costs
Net 1% = 4% – 1.2% – 1.2% -.6%
This is especially troubling if you were unaware that your plan qualified for a .5% discount on your expense ratio. Let’s say that you decided to use lower cost providers that decreased your fees by 1%. Even small differences in fees can translate into large differences in returns over time. The Securities Exchange Commission website says this about fee effects. “…if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858.”
Are your 401(k) fees reasonable and necessary?
As an investment fiduciary your job is to make sure that the fees are reasonable. The fee disclosure you should have received is a key to this analysis. Next, you would need a benchmarking report to see how you compare in cost and in services. Services can vary widely. Without a benchmark, it is difficult to know what is available and whether or not they help your employees pursue a reasonable retirement nest egg.
If you’re like most CEOs and CFOs that I know or small business owner you don’t have time to be as thorough in your analysis is I have been. That’s why I believe it is imperative that you find a competent retirement plan consultant. One that is willing to be a co-fiduciary, ERISA 3(21) investment advisor on your plan. This type of consultant would help with this type of analysis to help the company get more for the money that it spends on the plan. More importantly helping the participants (including you), the employees get on track to retire.
* Credit to Attorney Stacey Austin, Wang Kobayashi Austin
(1) The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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